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Many investors are getting worried about the possibility of a market crash – stocks can’t go up forever. But here at Millennial Money, we strive to go deeper than simple knee-jerk reactions.
Of course nobody can predict what the market will do in the short term, but it turns out that there are quite a few below-the-radar forces sustaining the market right now … that many investors are ignoring.
A few weeks ago, we explained how stock buybacks are propelling many companies higher. We also showed you how a handful of companies in Big Tech came to dominate the S&P 500’s returns.
But what we haven’t discussed is how Big Tech has been able to take over the S&P 500. (Hint: It’s the same reason so many Big Tech companies remain such great investments with plenty of growth ahead, even though they’ve already moved well beyond the start-up phase.)
It all comes down to how they leverage being a platform company.
The secret business model making Big Tech billions
Traditionally, when you do business, you have a buyer and a seller. The seller either manufactures a product to sell or buys a product from someone else in the hopes of selling it for a profit.
This is called a linear business model. Companies ranging from General Motors to Walmart embrace this legacy economic model.
It’s difficult to significantly increase your profit margin if you’re using a linear business model because labor costs increase yearly, and raw materials can become difficult to source. For example, all Big 3 automotive companies are closing manufacturing plants due to a lack of critical components. At the same time, consumers are price-sensitive and are willing to buy from competitors if you try to pass along all the cost increases.
Contrast this with a platform business model. Companies doing business this way facilitate transactions between buyers and sellers that get matched on the companies’ websites and digital properties, aka their platforms.
Instead of creating value through their supply chain, platform companies create value through the durability of their ecosystems: the network of buyers and sellers on their platforms.
It’s as if these companies are operating a toll booth, taking a piece of each transaction that happens on their platforms. That makes the platform business model highly scalable. For many platform companies, the incremental cost to provide more transactions is near zero because they’re merely an intermediary between two parties. It’s like they’ve discovered a profit hack!
And it gets even better: Compared with linear business models, platform businesses become less risky as they grow thanks to network effects (the more sellers you have on your platform, the more buyers that will attract, and vice versa).
How investing in platform businesses can make you money
It’s likely you have some money invested in Big Tech, and many of these companies use a full-platform or hybrid-platform approach in their business models. Here are four companies with platform businesses that are setting themselves (and the broader stock market) up for long-term success.
Platforms made Apple cool again (and rich!)
Even though investors and analysts spend a ton of time talking about Apple’s (Nasdaq: AAPL) iPhone sales, it’s important to remember that Apple is more than a device maker.
If you think back, it wasn’t really the iPhone that made Apple cool again. It was the iPhone’s predecessor — the iPod — whose sleek user interface rendered CD players obsolete. For investors, however, the brilliance of the iPod wasn’t in the product’s design. It was in the fact that the iPod was a platform device for the music industry, which made Apple a hybrid-platform company.
By getting into digital music downloads, Apple acted as a middleman, connecting buyers to artists and making a high-margin fee on every transaction. The fact that Apple became the de facto gatekeeper for digital music sales helped the struggling company transition back to mobile devices — a product category it all but abandoned after its Apple Newton fiasco years prior.
Apple continued to evolve as a platform company for music, eventually adding a recurring revenue subscription service – Apple Music – to its offering.
But that’s not the bulk of its platform revenue anymore. In 2020, Apple grossed more than $64 billion in App Store revenue. CEO Tim Cook has been clear about his desire to focus on better monetizing Apple’s ecosystem and its billion users, changing Apple’s reporting structure to include revenue from “Services,” now Apple’s second-largest division.
Admittedly, Apple’s platform business model is starting to raise eyebrows from regulators. Just this month, shares fell moderately when a judge partially sided with Epic Games in a lawsuit alleging that Apple’s 30% cut of App Store fees amounted to illegal bundling. As a result, Apple is going to allow app developers to create alternative payment methods that will cut Apple out of the process.
In the short term, this is a minor setback to Cook’s ambitions to monetize its platform. But Apple will likely find ways to profit from its ecosystem, such as charging app developers directly to use its site or users. Investors can rest assured that Apple’s ecosystem is too valuable not to monetize. Apple’s iPhone sales will continue to be cyclical, but the company’s long-term investment play will be led by continued growth in services.
Alphabet’s YouTube is a smashing success
There have been several great acquisitions in the technology industry, but very few have been as successful as Alphabet’s (Nasdaq: GOOG) YouTube purchase. In 2006, the company paid just $1.65 billion in stock to buy YouTube. Now the streaming video service has more than 2 billion monthly active users who have an account and probably millions more who watch videos without an account.
What Alphabet got at that time was a unique platform business, one that connects content creators to viewers and is monetizable by third-party advertisers. And since then, YouTube has benefitted from the shift among Millennials and Gen-Z away from cable packages (and the scripted content often written for and by Boomers) to innovative creators of their own generation instead.
YouTube’s network effects are becoming more entrenched, too. At that time of the acquisition, the service was uploading nearly 65,000 new videos daily and had 100 million daily views. Now 500 hours of video are uploaded every minute and the daily view count exceeds 5 billion per day (nearly one for every person on the planet).
With that large of a content library, there’s literally something for everyone … and with that many eyeballs on the site, content creators are making major bank. Last year, 9-year-old Ryan Kaji, YouTube’s No. 1 earner, made nearly $30 million from the site!
Of course, investors are also benefiting from YouTube as the service is growing in a major way. Alphabet recently disclosed that the social-media video network generated $15 billion in 2019 — at that time nearly 10% of Alphabet’s top line — and analysts expect that figure to jump to $29 billion this year.
As a point of comparison, that would put YouTube on pace with Netflix in terms of revenue. YouTube should continue to be a major growth catalyst for Alphabet for years to come.
Facebook is a pure-play platform company
Facebook (Nasdaq: FB), unlike the other companies I’ve discussed here, essentially owes its entire revenue stream to the platform model. Investments by the company to build out its user base have been uber-successful, and Facebook is now one of the most influential companies in the world. If you’re a consumer-facing brand, you must have a Facebook presence.
Currently the company has an ecosystem of nearly 3 billion monthly active users, which is more than one-third of the population of the entire planet. Facebook’s network effects are so powerful that the Brookings Institute refers to it as a “new public utility” (along with YouTube’s parent company Alphabet).
Like YouTube, Facebook’s social-media platform business is monetized by third-party payers. But unlike YouTube, the company doesn’t have a revenue-sharing agreement with most content creators.
The brilliance here is that users provide value by posting content that their friends and families interact with — and as the “product,” Facebook collects information on users’ interests and then provides it to advertisers. Facebook’s business model is highly scalable since the cost to add another user is nothing and the free-to-consumer nature encourages users to sign up.
Still, investing in Facebook isn’t risk-free. Increasingly, we’re seeing the limits of extreme scale. Politicians on both sides of the aisle, both at the federal and state levels, are faulting the company for not doing enough to root out hate speech and misinformation on its platform. This will continue to be an issue for Facebook as it’s unlikely to ever hire enough employees to prevent all bad actors.
Ultimately, I think the company will be able to prevent the worst excesses and will continue to increase revenue by monetizing its massive user base. Although user growth will be more difficult going forward, the company has only scratched the surface on how to monetize its 3 billion monthly active users.
Amazon’s growth is driven by its platform
It’s widely noted that Amazon (Nasdaq: AMZN) is the largest e-commerce company in the United States. eMarketer estimates that the company’s market share will be 40.4% of all digital sales this year. Although this is technically true, some nuance is required because the bulk of Amazon’s sales are not from the company itself but rather from its e-commerce platform.
Behind the scenes, Amazon’s e-commerce operations are a hybrid business model. For many items available on its platform, the company operates as a traditional linear retailing business that it calls first-party sales. Here Amazon buys products in bulk and sells them direct-to-consumer, controlling pricing, inventory levels, and sales strategy in a similar manner to Target or Walmart.
However, it also operates as a third-party platform where vendors can list their products on Amazon’s website, taking advantage of the company’s massive ecosystem. As noted above, the majority of Amazon’s ecommerce sales — 56% — were from these third-party merchants. In fact, third-party sales have met or exceeded 50% every quarter since 2016.
Third-party sales are a win-win for all parties: Merchants gain exposure to millions more customers, Amazon can offer significantly more products without the risk of taking on inventory that can spoil or go obsolete, and customers are able to have a one-stop digital shopping experience, many with free 2-day shipping from Amazon’s Prime product.
Third-party sellers are beneficial for Amazon investors because they allow the company to monetize its platform and earn high-margin seller fees and ancillary support services like Fulfillment by Amazon and advertising revenue.
Last quarter, Amazon’s third-party growth and its importance to the bottom line was on full display. The company’s 27% revenue growth missed analyst estimates, but the company smashed expectations for profit thanks to strong growth in its “other” division (mostly advertising) and in third-party seller services, which grew 87% and 38%, respectively.
The long-term trends boosting e-commerce will keep on trucking, and Amazon’s ecosystem and relationship with third-party sellers will continue to be a source of competitive advantage for it against other online vendors.